A Non-linearity in the Inflation-Growth Effect

Abstract:     
The paper shows how increases in the inflation rate can cause the output growth rate to decrease by a lessor amount as the inflation rate rises. This is the so-called non-linearity in the inflation-growth effect. Our explanation helps show how model-based estimates of the inflation-growth effect can be consistent with evidence. The model includes an explicit credit service sector that allows avoidance of the inflation tax and that induces and increasingly interest elasticity of money demand. The increased use of credit as the inflation rate rises, and the increase elasticity of substitution between money and credit, means the agent relies increasingly less on leisure to avoid the inflation tax. This lessens the negative effect of inflation on endogenous growth at higher rates of inflation. We present both a closed form solution to develop the intuition and a set of calibrations of the baseline model, of more standard case-only, and cash good/credit good models, and of the baseline extended to included physical capital. The paper also shows how the economy is a special case of the shopping time exchange model. The added micro-foundations allow in addition calibrations of how financial development affects the non-linearity and the magnitude of the inflation-growth effect.

JEL Classification: O11, E13, E51, E41, E31, E22

working papers series